RBI's under-fire inflation forecast set for sizeable upward revision

Reserve Bank of India (RBI) Governor Shaktikanta Das.

Speaking at an industry event on March 21, Reserve Bank of India (RBI) Governor Shaktikanta Das was quizzed on how domestic inflation would evolve in the coming months. Das sidestepped the question, saying the central bank was still working on its forecast and the numbers were "still on the drawing board".

There is a good chance the RBI's economists will be at the drawing board right up to the last minute.

The day after Das' interaction, oil marketing companies raised petrol and diesel prices by over 80 paise/litre. A hike in the price of domestic liquefied petroleum gas cylinders by more than Rs 50 quickly followed. The previous week, bulk diesel prices were increased such that they exceeded retail prices by Rs 25 a litre. The result can't be any good when it comes to inflation.

The situation was rather dire even before fuel prices were hiked after 137 days. Data released on March 14 showed Consumer Price Index (CPI) inflation rose to 6.07 percent in February from 6.01 percent the previous month.

While the rise in inflation wasn't much, it was nevertheless unexpected. And economists see it coming in above the upper limit of the central bank's 2-6 percent mandate for a third consecutive month in March, data for which will be released on April 12. This means inflation would exceed the RBI's forecast of 5.7 percent for January-March unless it falls to at least 5.1 percent this month.

Fear of failure?

The MPC is deemed to have failed when average CPI inflation is outside the 2-6 percent band for three consecutive quarters. With all indications being that inflation will average more than 6 percent in the first quarter of 2022, that leaves us with April-June and July-September.

The RBI's current forecast says headline retail inflation will average 4.9 percent and 5.0 percent in the next two quarters and 4.5 percent in FY23. These numbers, however, are seriously outdated.

Nomura recently revised its already-high inflation forecast for 2022 of 5.9 percent to 6.3 percent. According to Nomura, domestic petrol prices must be increased by as much as 24 percent, or Rs 25 per litre, over the next few months to bring them on the same level as market prices. This week's price hike accounts for only a small fraction of that estimated increase.

Admittedly, Nomura has been one of the more hawkish commentators, with their economists predicting the MPC will be forced to increase the repo rate at its June meeting, and pencilling in a total of 100 basis points of rate hikes for 2022. But others too expect a big increase in the RBI's inflation forecast next month. QuantEco Research, for instance, now sees CPI inflation averaging 6.1-6.3 percent in FY23, or 80-100 basis points (bps) higher than its previous forecast.

"It's possible the RBI's inflation forecast has also increased by a similar margin since we were pegged at around 5.3 percent and have raised it by 80-100 bps,” said Yuvika Singhal, economist at QuantEco Research. "I don't see any reason why the RBI would not raise its forecast to the same extent. So their forecast of 4.5 percent for FY23 will probably be closer to 5.5 percent."

Much depends on the price of India's crude oil basket assumed by the RBI to forecast inflation. The October edition of the Monetary Policy Report revealed the central bank assumed a price of $75 per barrel for the second half of FY22. However, the average price of India's crude oil basket was $83 a barrel in October 2021-February 2022. The prices in March will only raise this figure for the latter half of the year.

While QuantEco has assumed a crude oil basket price of $100 a barrel for FY23, Morgan Stanley has pegged it at $110 per barrel, resulting in a CPI inflation forecast of 6 percent for the next financial year.

"We opine CPI to remain above the 6 percent mark until September, and only decelerate to 5.6 percent by Q4 2022," Morgan Stanley said in a note on March 14.

If CPI inflation remains above 6 percent until September, the MPC would fail to meet its mandate for the first time, having only avoided doing so in 2020 on the technicality that inflation based on imputed data constituted a break in the CPI series.

In his interaction on March 21, Das said there was only a "very, very remote possibility" that inflation would keep exceeding 6 percent.

Inflation optimism

The pandemic has seen a shift in the manner in which the MPC has targeted inflation, moving from the medium-term target of 4 percent to keeping it in the 2-6 percent band. Failure, then, seems to be the only reason that may force the committee to act.

A sharp upward revision in the inflation forecast will influence expectations. And the RBI has seemingly been keen to manage expectations through its inflation forecasts. The projections announced on February 10 had surprised most economists, with Rajni Thakur, RBL Bank's chief economist, noting on the day it was likely "RBI is trying to buy time and focus on managing rates expectations" for the remainder of FY22.

Could the same be done on April 8? One way to do so would be to assume a lower crude oil basket price using the argument that the current high levels were unlikely to sustain for long. With the Monetary Policy Report set to be released next month, there will be no hiding the crude oil price underpinning the forecast.

The inflation forecasts may also not get a sharp bump up if the central bank thinks the government may cut the fuel excise duty or if the pass-through to pump prices is unlikely to be large. A third way out could be to pin hopes on food inflation softening the blow from higher fuel prices and their second-round effects.

"But clarity on food inflation dynamics only emerges around the end of July and the start of August," pointed out Singhal of QuantEco Research.

Transparency and predictability are the cornerstones of the flexible inflation targeting framework. But for it to remain so, the RBI's inflation forecasts—like Caesar's wife—must be above suspicion.